Models of Fiscal Policy, the Trade Deficit, and the Dollar

Paul Krugman writes:

Robert Rubin is wrong about the dollar: He says: “You could have had [budget] surpluses that affected the savings rate and would have helped the trade balance. I think you would have had more confidence in the policy framework and you would have had a [stronger] dollar.”...

This is what John Williamson of the Institute for International Economics calls “the doctrine of immaculate transfer.”... Here’s a (somewhat) plainer English version:

The problem becomes apparent if one asks how a higher savings rate translates into a smaller trade deficit. It is not enough to insist that the accounting ensures that it must. A consumer deciding between a Ford and a Honda cares nothing about the US’s national income accounts. How does a lower US budget deficit persuade Americans to buy fewer foreign goods and foreigners to buy more US products?...

The chain of events would look something like this: a fall in the budget deficit reduces demand in the US economy; to avoid a recession, the Federal Reserve lowers interest rates; as a result, the dollar falls; this lower dollar makes US goods cheaper compared with foreign substitutes, causing the necessary switch in expenditure.... [I]t is naive to imagine that changes in the government’s financial balance can translate directly into changes in physical trade flows, without working through a mechanism such as the exchange rate. That is the fallacy of ‘immaculate transfer’ - confusing the accounting principle which says that the current account balance equals the savings-investment balance with the process that enforces that constraint on decision-makers...

And apparently the old fallacy continues to hold sway.

I think that Rubin is implicitly working in a different model than the NIPA-based monetarist workhorse that Krugman (and I!) instinctively reach for first. I think that in Rubin's mind the chain of causation looks something like this:

1. A government establishes a sane, balanced long-run fiscal policy.
2. Businesses conclude that the country is a safe one in which to invest to build export capacity: since they do not fear future random and confiscatory taxation or inflation, factories making internationally-traded goods that would have been built abroad are built here at home instead.
3. With more export capacity at home and less abroad, exports rise and imports shrink at the current exchange rate.
4. Supply and demand leads the domestic currency to appreciate in order to balance trade.

Rubin's channel is: good fiscal policy --> expanded export supply --> export surplus --> higher currency value.

By contrast, Krugman's channel is: good fiscal policy --> lower domestic interest rates --> reduced currency value --> export surplus.

Which side am I on? I tell my undergraduates:

• At a time horizon of 0-3 years, be a Keynesian: the most important things are the fluctuations in unemployment, in real demand, and in capacity utilization.

• At a time horizon of 3-8 years, be a demand-side monetarist: you can assume (provisionally) that fluctuations in employment, real demand, and capacity utilization die out; the most important things are the fluctuations in the composition of real demand (investment vs. consumption vs. government vs. net exports) and in inflation- and deflation-causing nominal demand assuming (provisionally) stable growth of the economy's productive capacity.

• At a time horizon of 8 years or greater, be a sane supply-sider: the most important things are the processes of investment in physical, human, and organizational capital that raise the economy's productive capacity.

Thus I was happy telling my undergraduates in 1985 that the reason the dollar was strong was because of the five years of Reagan deficits--high domestic interest rates, you see, pushing up the value of the dollar (and raising the trade deficit). And I was happy in 1992 telling my undergraduates that the reason the dollar was weak was because of the twelve years of Reagan-Bush deficits--large budget deficits starving the economy of capital that made us less productive than in some counterfactual in which we had elected some Eisenhower Republican in 1981.

And so today I call this one for Paul Krugman: we are only in year six of the Bush II derangement of American fiscal policy, and so I think the dollar is a little higher than it would be if the U.S. budget deficit were lower. But in two years I may have a different answer.